FBT removed in Budget 09-10. Time to rejoice? Think again

In yesterday’s Indian Union Budget 2009-10, the Fringe Benefit Tax (FBT) has been proposed to be abolished. The FBT has been a pain for ESOP holders, ever since ESOPs were brought under FBT in 2007. Since then, Employee Stock Option Plans (ESOPs) have had to pay the FBT on the notional value of the ESOPs. The notional value of the ESOPS = Fair Market Value on vesting date – exercise price. And the FBT rate was a huge 30% per cent plus applicable surcharge plus education cess. Note that the FBT was actually an employer tax which was happily being passed by most employers to the employee. Nothing like being an employer in India, right?

Contrary to what you might think, removal of FBT does not mean that taxation of ESOPs will stop. All that has happened is that the taxation in the hands of the employer has been shifted to the employee. So ESOPs, among other items will be treated as perquisite in the hands of the employee and taxed at the prevalent slab rates. Which for most of us will change nothing at all.

The only silver lining that I can see is in the calculation of the notional value of the ESOPs. Previously, the employee had no say in the matter, the notional value was the difference between the Fair Market Value on vesting date – exercise price. Now it will be Fair Market Value on exercise date – exercise price. The vesting date is not under the employee’s control, but the exercise date is. Prices of stocks fluctuate… by waiting for an opportune time, one could decide the exercise date at a point where the stock price is agreeably low, and hence reduce the FMV. A long term sale subsequently will reduce the capital gains to 0, hence one can profit from a low FMV.

Lets look at this with an example

An employee is awarded X shares under an RSU plan, with a vesting date 4 years in the future. The RSUs are awarded at face value, say INR 2.

4 years later, on the vesting date, the stock price is at an all time high of INR 102 i.e. the FMV = INR 102. After the vesting date, irrespective of when the employee exercises his options (i.e. buys the shares from the company), the notional value per RSU is already fixed = INR 100. Even if the employee exercises his options later, he has to pay FBT of about INR 34 per option when he exercises.

Say, after the vesting date, the employee waits for another 6 months or a year before deciding to exercise. Now consider a market crash, as has happened. IT stocks being particularly susceptible, would steeply drop. The stock price drops to INR 32. The RSUs are almost worthless now! The notional capital gain is INR 30 per RSU. While the employee has to pay INR 34 to the government per RSU. Unless one is sure that the stock price will increase drastically in the future, there is no point in exercising the RSU. (And if someone says he is sure about the stock market, he’s either stupid or joking.)

With the new taxation rules, the same situation is much better. Say, the employee decides to exercise at INR 32, he will pay a perq tax of about INR 9 (at a marginal tax rate of 30%).

Even without a market crash, one is perhaps better off since the price of stocks varies over a period of time. Perhaps the stock price was at an all time high around the vesting date (as in the example above, at INR 102). A few months later, any number of real or imaginary concerns can bring down the price sharpely. Say the stock price drops to INR 62. Thus the perq tax that needs to be paid is about INR 18. Thats nearly half the previous FBT per RSU.

Finally, after exercise of the stock options, the employee should wait for a year before making a sale, which would be a long term capital gain and hence exempt from tax.